It is rare for former central bankers to criticize the performance of their successors. But, in an interview this week with The Wall Street Journal, Rakesh Mohan blamed the Reserve Bank of India’s relatively hands-off currency policy for the rupee’s plunge and, until recently, the acute shortage of cash in the domestic banking system.

Mr. Mohan served two stints as the deputy governor in charge of monetary policy between September 2002 and June 2009. From October 2004 to July 2005, he was economic affairs secretary in India’s finance ministry. He was also a contender to succeed Y.V. Reddy as RBI Governor when the latter’s term ended in 2008.

Edited excerpts.

WSJ: What is the way out of the high inflation, and the slow growth situation the economy is in?

Mr. Mohan: As of now, we have fiscal dominance and, in such a situation, monetary policy loses traction. Thus, what is more important than monetary policy at present is whether the government can take policy measures that give rise to a change in expectations on the probability of the fiscal situation improving significantly in the foreseeable future.

So the key issue is the need for immediate action on reducing the [diesel] subsidy, which, admittedly, is politically very difficult. That would have a triple effect: first, demonstration of political commitment on repairing the economy; second, actual improvement of the fiscal situation in the short term; and third, through its effect on the demand for petroleum products, the possibility of a lower current account deficit and reduced pressure on the exchange rate. To some extent we are being helped by the fall in international crude prices, so such an action is relatively easier to do right now.

The second action that can be taken is tweaking of the various plan expenditures on the social sector, which are essentially focused on human resource development and welfare expenditures. I believe these schemes are very important for us, but they could be reoriented toward investment in rural infrastructure. In particular, expenditures on the rural employment guarantee scheme should be meshed with all the other rural programmes so that duplication is eliminated, assets are created and overall expenditures reduced.

Third is speeding up of infrastructure expenditures that are already budgeted and clearing up the cobwebs that currently constrain implementation of even approved Public Private Partnership projects. In each of these areas, announcements should be made only after the action is taken, and not ex ante as is currently being done, without follow up.

WSJ: Has the potential growth rate of the economy fallen over the past few years?

Mr. Mohan: In terms of potential growth, assuming we can fix the fiscal situation, get the external account in order and get back to a sustainable 2.0% to 2.5% current account deficit in two to three years, we should be able to get back to a gross saving rate of about 35% and corresponding investment rate of 37% plus.

It is equally important to ensure that these domestic savings are deployed productively rather than used to soak up fiscal deficits. If we achieve this, I don’t see why we can’t have a potential growth rate of 8.5% to 9.0%.

However, I don’t expect this to fructify over the next five years because last year’s growth was only 6.5%; and this year it is difficult to expect more than 6.0% to 6.5%. It will therefore take some time to get back to a higher growth path. And this also supposes that the Europeans will solve their problems to some extent and there is some degree of normalcy in the rest of the world.

If Europe breaks down, one can’t predict what will happen. In the longer term, as the weight of Asian economies grows, even if Europe suffers from significant stagnation, Asian demand will increasingly substitute for the lost European demand.

WSJ: What are the causes of the liquidity problems? No one seems to have a definitive answer.

Mr. Mohan: There has been a structural problem. There is some relationship between real GDP growth, nominal GDP growth, broad money and base money. These are not very stable relationships. But at a very broad level, suppose there is 8% real GDP growth, 7% inflation, so something like 15% to 16% nominal GDP growth.

That corresponds to 18% to 20% broad money growth, assuming there is some financial deepening going on. And that implies 14% to 16% base money growth which is the expansion of the RBI’s balance sheet.

So, if you have this kind of nominal GDP growth you need to have a similar level of base money growth. If you look at previous periods, that was taking place through forex reserve accumulation.

What happens is when you have excess capital coming in, you buy dollars, put it in forex reserves, thereby injecting that liquidity. In the years 2005 to 2008, the flow was much higher compared to the expansion we needed so we had to buy the stuff.

But, one thing that a lot of people don’t understand is that for this kind of expansion, excess capital inflows are good for the economy even if they exceed the current account deficit. The Reserve Bank’s assets need to increase by around 15% a year; at present, by about $50 billion to $60 billion a year.

So with excess capital flows, forex reserves can increase in a sustainable manner while simultaneously increasing the needed liquidity in the system. If you don’t accumulate foreign assets you would have to accumulate equivalent domestic assets.

So the RBI would have to buy equivalent volumes of domestic securities, which can then foul up the working of the government securities market. In 2010-2011, when we were getting excess capital flows, we didn’t intervene. And that caused two problems–one, that the exchange rate was allowed to become overvalued and the current account deficit widened and, second, we created problems in liquidity management.

WSJ:Most of the steps to support the rupee have aimed at attracting capital inflows. Is that the right way to go about it, or is there no other option in the short-term?

Mr. Mohan: What is important, really, for capital flows is instilling greater confidence in the Indian economy–in its macro management, in its monetary policy, in its fiscal management. I think it is very risky to open the debt capital account in the way that it is being opened because all the research on open capital account, including now by the IMF, which wasn’t the case earlier, has shown that the most fickle capital flows are debt flows.

The problem is when you take these measures, it is very difficult to reverse them because that further increases the risk perception. So, these kinds of measures have to be taken very, very carefully, especially given the existing inflation and interest-rate differentials with the rest of the world.

In some sense, we are lucky. Despite this opening, given the confidence level being where it is, money hasn’t flooded in! What happens in such situations is that debt capital can flow in and out very fast. With yields on Indian government securities being 8% to 9% and those on similar foreign securities at 1% to 3%, there is huge arbitrage available.

If capital flows in, it would have an impact on the exchange rate upwards and there will be a huge incentive to flow out quickly while the going is good, thereby injecting significant financial instability into the system. So, this has to be done extremely carefully. Such opening of the capital account should be done during times of strength and not during the converse as at present.

WSJ: So what can be done in the short-term to support the rupee?

Mr. Mohan: You have to instill confidence. There is no quick fix. The government has to demonstrate its commitment to revitalize the economy through a credible stabilization package.

What is essential is some front-loaded action which provides confidence that the government is firmly in charge. We also need to recreate confidence in the market in our ability to manage the external account through active intervention on both sides in the forex market, as we’ve done earlier, without of course fixing the exchange rate. We have had a policy of a managed float but without an exchange rate target.

The exchange rate should neither appreciate very fast nor depreciate rapidly, but it should fluctuate. The rupee should reflect fundamentals and not the vagaries of capital flows. It is very important to note that the exchange rate change that has taken place in recent months is really more of a correction than a precipitous fall, as is being portrayed.

We breached 50 rupees to the dollar in late 2008 so we have had a nominal exchange rate depreciation of 10% to 15% over about 30 months. Given the inflation differential with the rest of the world, that is nothing to be alarmed about.

This inflation differential is mirrored in the significant real exchange rate appreciation that we have seen, and as a consequence the merchandise trade deficit has shot up to an unsustainable 10% of GDP. Even if oil and gold are excluded, that is a massive merchandise trade deficit.

It demonstrates that our exchange rate is highly overvalued at least from the point of view of the manufacturing sector. Consequently, manufacturing growth has really plummeted. You can’t get 8.5%-9% long term sustainable GDP growth unless manufacturing growth is higher than that. i.e. is about 10% plus in the future. It has been nowhere near that for the last 10 years.

And so, a big issue to my mind, is appropriate management of the exchange rate for the foreseeable future. I’m not suggesting at all that we fix it like China. I think we have enough experience managing it as a managed float. And we should take advantage of that long experience.

WSJ: And what about interest rates?

Mr. Mohan: As I had said earlier, monetary policy has lost traction in the current situation. If you have inflation at 10% and total government borrowing at 8% to 9 % of GDP, there is little chance of market interest rates coming down even if policy rates are reduced.

You can’t wave a wand to bring them down. They can only come down if you do better overall fiscal management and inflation starts coming down. You have to bring down inflation expectations.

But with government borrowing where it is, inflation expectations where they are, even if the RBI did policy rate cuts, I would be very surprised if it has any major impact on real interest rates in the economy.